(Ab)Use of Leverage, Short Sales, and Options by Mutual Funds

54 Pages Posted: 22 Mar 2017 Last revised: 23 Jan 2018

Paul Calluzzo

Queen's University - Smith School of Business

Fabio Moneta

Queen's University - Smith School of Business

Selim Topaloglu

Queen's University - Smith School of Business

Date Written: January 20, 2018

Abstract

We study the use of leverage, short sales, and options by equity mutual funds and find that their use is associated with poor performance. Our results suggest that moral hazard and agency costs contribute to this underperformance. Consistent with moral hazard, funds that use these complex instruments hold high-beta equity positions that are associated with low risk-adjusted returns. They then attempt to use the instruments to reduce the risk of their portfolios, but in an imperfect and costly way. We also find evidence that funds use complex instruments to manipulate risk following poor performance. The negative outcomes associated with complex instrument use dissipate in funds that are well-monitored, well-incentivized, transparent, and invest in low-beta stocks. Our results suggest that investors are better off choosing simplicity over complexity.

Keywords: mutual funds, leverage, short sales, options, complex instruments, fees, performance, risk

JEL Classification: G11, G23

Suggested Citation

Calluzzo, Paul and Moneta, Fabio and Topaloglu, Selim, (Ab)Use of Leverage, Short Sales, and Options by Mutual Funds (January 20, 2018). Available at SSRN: https://ssrn.com/abstract=2938146 or http://dx.doi.org/10.2139/ssrn.2938146

Paul Calluzzo

Queen's University - Smith School of Business ( email )

Smith School of Business - Queen's University
143 Union Street
Kingston, Ontario K7L 3N6
Canada

Fabio Moneta

Queen's University - Smith School of Business ( email )

Smith School of Business - Queen's University
143 Union Street
Kingston, Ontario K7L 3N6
Canada

Selim Topaloglu (Contact Author)

Queen's University - Smith School of Business ( email )

437 Goodes Hall
143 Union St.
Kingston, Ontario K7L 3N6
Canada
613-533-6573 (Phone)
613-533-2321 (Fax)

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